Economics of Bitcoin as a Settlement Network

Saifedean Ammous

May 19, 2017

As Bitcoin’s popularity continues to increase, its transaction fees rise as well, leading to the customary chorus of doom and gloom by those still stuck in stage 1 of dealing with Bitcoin grief. With average transaction fees exceeding $2, the doom-mongers assure us Bitcoin is doomed, because nobody wants to pay $2 to make a payment, when credit cards, paypal, and many other options charge far less transaction costs.

The problem here, as usual, is not with Bitcoin, but with people’s misunderstanding of Bitcoin, and the first clue to that can be found in the sky-rocketing price: if Bitcoin is so doomed, why are people still buying it? The answer is that Bitcoin’s value proposition is not in making the small consumer purchases, but in making large and important payments, particularly across borders. Payments in person, for small amounts, can be conducted in a wide variety of options: physical cash, barter, favors, credit cards, bank checks, and so on. Payments across the world, however, are a very different story.

There are only a few currencies that are accepted for payment worldwide, namely: the US Dollar, the Euro, gold, and the IMF’s SDR’s. The vast majority of international payments are denominated in one of these currencies, with only a tiny percentage shared by a few other major currencies. To send these currencies in values around thousands of dollars internationally costs dozens of dollars usually, and is subject to invasive forensic examination by financial institutions. Compared to these transactions, Bitcoin’s transaction fees of $2.5 are still a bargain.

However, the volume of these international flows is far larger than what Bitcoin’s blockchain can handle, and if more such payments move to Bitcoin, fees will rise to limit the demand for them. Yet, that would also not spell doom for Bitcoin, because sending these individual payments is not the limit of Bitcoin’s capabilities.

Bitcoin is money free of counter-party risk, and its network can offer final settlement of large volume payments within minutes. Bitcoin can thus best be compared to settlement payments between central banks and large financial institutions, and it compares favorably to them, being infinitely cheaper and more verifiable. The only other form of money in history which is free of counter-party risk is gold, and moving that around is incomparably more expensive.

An interesting thought experiment is to imagine the shape of a global economic system built around settlement in Bitcoin. Bitcoin’s current capacity is to verify around 350,000 transactions per day. This number of transactions can allow a global network of 850 banks to each have one daily transaction with every other bank on the network. (The number of unique connections in a network equals n(n-1)/2, where n is the number of nodes.)

Bitcoin can support an international network of 850 central banks capable of performing daily final settlement with one another. Such a network would have two major advantages over the current network of central banks: First, the finality of settlement on Bitcoin does not rely on any counter-party, and does not require any single bank to be the de facto arbiter, making it ideal for a network of global peers, rather than a global hegemonic centralized order. Second, the Bitcoin network is based on a form of money whose supply cannot be inflated by any single member bank, making it a more attractive store of value proposition than national currencies whose creation was precisely so their supply can be increased to finance governments.

In a world in which no government can create more Bitcoin, these Bitcoin central banks would compete freely with one another in offering physical and digital Bitcoin-backed monetary instruments. Without a lender of last resort, fractional reserve banking becomes an extremely dangerous arrangement, and the only banks that’ll survive in the long-run would be sound money banks offering financial instruments 100% backed by Bitcoin. They would settle payments between their own customers off of Bitcoin’s blockchain, and then perform final daily settlement between each other over the blockchain.

I am currently writing a book, available on Amazon here, explaining Bitcoin’s main value proposition as a sound money, and elucidating the significance of this concept across history, which far exceeds the significance of small transaction costs on consumer payments. Sound money has been a necessary building block of human civilizations, and its demise has usually coincided with civilizational decline. The modern world was built in the 19th century on sound money, funded by investors with the low time preference engendered from a sound money. The consumerist culture of instant gratification of the twentieth century, on the other hand, was the culture of ever-devaluing fiat money, which discourages saving, and incentivizes short-term orientation.

The obsession with consumer payments in the Bitcoin community is an unfortunate relic of the fiat money era. Generations that have only known monetary hot potatoes that need to be spent before they devalue have come to view life as a quest of mass consumption. In a world of sound money, people will still consume, of course, because they need to survive. But consumption will come at a high opportunity cost in the future, since savings appreciate. As result, consumption will stop being a compulsive part of life, and people will buy things they need, and things that last for a long time. Instead of wasting their money on plastic bullshit they don’t need and expensive sugary addictions, people will save their money for the future, and watching it appreciate, achieve financial independence.

The number of transactions in a Bitcoin economy can still be as large as it is today, but the settlement of these transactions will not happen on Bitcoin’s ledger, whose immutability and trustlessness is far too valuable for individual consumer payments. The reality is that buying a coffee does not require the level of security and trustlessness that Bitcoin offers; it can be more than adequately handled on second layer solutions denominated in Bitcoin. Using Bitcoin for consumer purchases is akin to driving a Concorde jet down the street to pick up groceries: a ridiculously expensive waste of an astonishing tool. Consumer payments are a relatively trivial engineering problem which the modern banking system has largely solved with various forms of credit and debit arrangements. Whatever the limitations of current payment solutions, they will stand to benefit immensely from the introduction of free market competition into the field of banking and payments, the most sclerotic industry in the modern world economy, owing to its control by governments that can print the money on which it runs.

If the consumer-payments view of Bitcoin were correct, the rise in transaction fees would hurt adoption of the network, leading to stalling in the price, or a drop, as the network is relegated to the status of a curiosity. On a day in which the price of a Bitcoin hit $2,000, this is becoming an increasingly untenable argument. From the settlement layer view, the growing adoption of Bitcoin is increasing its liquidity internationally, allowing it to compete with global reserve currencies for increasingly more valuable transactions, causing transaction fees to rise. As this processes continues in the future, expect much higher transaction fees, and a global Bitcoin settlement network to grow in importance.